Originally published by AMP Capital
As expected the Fed left rates on hold at its January meeting. It sees US growth as “solid” but this is a slight downgrade from describing it as “strong” last month and Fed Chair Powell referred to various “cross currents” that had clouded the outlook including slower growth globally, tighter financial conditions and muted inflation.
Consistent with this, its comments were dovish on interest rates – replacing a reference to “further gradual” rate hikes with being “patient” as it determines what to do on rates…which leaves open the possibility that the next move may even be a rate cut.
It also signalled a more dovish approach to its process of returning its balance sheet to more normal levels – or what has become known as Quantitative Tightening – indicating that it will maintain an “ample supply of reserves”, is prepared to adjust its QT program in the light of economic and financial developments and that it will use all tools including changing its balance sheet if warranted. This is consistent with the Fed ending its QT program at a higher level for its balance sheet than had previously been expected and that it is prepared to increase it again (ie do more Quantitative Easing) if needed. If the end point for the Fed’s balance sheet is around $US3.5trn as opposed to around $2-2.5trn as previously thought then at the current rate of rundown it will be reached by early next year, implying that the Fed will signal a slowing in Quantitative Tightening at least by later this year even if economic conditions are okay.
Our assessment is that the Fed will be on hold regarding rates for the next six months at least.
Confirmation that Fed is not on “autopilot” when it comes to rate hikes and Quantitative Tightening but will be flexible on both to keep the expansion going and meet its inflation objectives and that its aware of the volatility in financial markets and various threats to growth is very positive for financial markets and so shares rallied strongly and the US dollar fell on the news.
The Fed’s move is akin to its pause in response to share market falls and slower growth in early 2016 (that did not see the Fed resume rate hikes again until late 2016). It ticks of one condition for shares to do better this year – others include Chinese stimulus getting the upper hand, ECB easing, continuing progress in US/China trade talks, a decisive end to the US government shutdown dispute and signs the US debt ceiling will be raised relatively smoothly, a bottoming in profit revisions and good earnings reporting seasons globally and in Australia, stronger than expected economic data and a bottoming in PMIs and share markets breaking through resistance on strong breadth. Some of these are still likely to drive volatility and setbacks in shares (as deep V style rebounds from falls like those seen last year are unusual) but at least we are making progress.
For Australia, a more dovish Fed may help reduce upwards pressure on bank funding costs and so out of cycle bank mortgage rate hikes – but so far there has not been much sign of this and much of the reason for higher funding costs were arguably home grown anyway. In terms of interest rates – the RBA has been diverging from the Fed on rates for over a decade now so a Fed pause won’t have much impact on what the RBA does on the cash rate where we still expect cuts this year.
The bigger impact on Australia may come via the Australian dollar as a more dovish Fed may help reduce downwards pressure on the Australian dollar. In fact, the Australian dollar bounced further overnight on confirmation that the Fed is dovish on top of the boost it got from higher iron ore prices on the back of Vale's (NYSE:VALE) problems. Ultimately we still see the Australian dollar heading into the $US0.60s though as the gap between the RBA’s cash rate and the Fed Funds rate will head further into negative territory as the RBA moves to cut rates this year.